The possibility of Scottish independence is back on the political agenda once again. And one question – which currency would an independent Scotland use? – that was crucial in the 2014 referendum has still not been resolved.
The informal use of the pound is a very risky option.
To see why, the Scottish National Party (SNP) might look at the problems which Facebook is having in getting its proposed digital currency libra off the ground. Already, companies like PayPal, Visa, Mastercard and Ebay have withdrawn as potential sponsors.
While Facebook is a company and Scotland is a country, the issue is how the currencies are backed.
Facebook proposes to back the libra by its accumulated profits held in a portfolio of “low volatility assets”. But as Barry Eichengreen of the University of California points out, “anyone who lived through the 2008 global financial crisis will know that low volatility is more a state of mind than an intrinsic attribute of an asset”.
In the face of an unexpected adverse shock to the values of these assets, Eichengreen notes that these will be subject to the equivalent of a bank run. But there is no lender of last resort able to simply print money.
By simply using sterling, as many Latin American countries do with the US dollar, the Scots would have no means of printing money if their banks were attacked in a financial crisis. Taxes would have to rise massively to support the banks.
The Scots could instead apply to join the euro. An immediate problem with this would be the rule in the Stability and Growth pact that countries in the Eurozone should keep their budget deficits below three per cent of GDP.
The UK spends only 1.1 per cent of GDP more than it raises in taxes. Ironically, this would make us a shoo-in for euro membership, if Britain as a whole wanted to join.
In contrast, the latest figures produced for Government Expenditure and Revenue for Scotland show the nation running a public sector deficit of seven per cent of GDP.
This is obviously much higher than would be allowed in terms of membership of the euro. It is, in fact, the highest in the whole of Europe, the next highest being Cyprus at 4.8 per cent. So to join the euro, the Scots would have to make large cuts in public spending.
If instead they decided to set up their own currency, the markets would almost certainly force similar public spending reductions on them. After all, small countries running large public deficits tend not to be viewed kindly.
This problem has been magnified dramatically by the statement by Derek Mackay, the Scottish government finance secretary, that an SNP government in an independent Scotland would refuse to repay its share of outstanding UK debt.
A massive public sector deficit and defaulting on government debt is hardly a very sound basis on which to launch any new currency.
The desire for independence is often driven by emotion rather than rational calculation. But unless the currency question is addressed and solved, an independent Scotland would live to rue the day.
As published in City AM Wednesday 23rd October 2019
Image: Scottish Independence March by Christine McIntosh via Flickr licensed CC BY-ND 2.0
This year’s Nobel Prize in economics, announced on Monday, was a ray of sunshine amid the prevailing media gloom.
The Prize was awarded for the work the new laureates had done on the alleviation of global poverty. This is one reason to be cheerful about it. Another is that Esther Duflo became only the second ever woman to win the prize, along with her close collaborators Abhijit Banerjee and Michael Kremer.
In addition, the winners have made important developments in how economists go about solving problems. These individuals are a key part of the drive to move economics on from an obsession with pure theory towards making it much more empirically-based.
At first sight, the award is very conventional. The laureates retain the basic view of economists: poor people are essentially rational agents, trying to take decisions which are in their own interests.
They may have much more difficulty in accessing relevant information than others, and face many more constraints on their ability to make the best decision. But they are just as rational as everyone else.
The similarity with tradition ends there. For the laureates’ main innovation is to introduce the use of randomised controlled trials (RCTs) into economics.
One hundred years ago, the British statistician Ronald Fisher was revolutionising the principles of statistical analysis. The maths that he developed enabled the testing of new medicines to become much more scientific.
The basic idea is to have a group of people who take the new drug and a group who do not. The key thing is to assign them into the groups purely at random. This way, any difference in the outcomes of the group which was treated and the group which was not can reasonably be thought to be due to the impact of the drug.
Duflo and her colleagues, along with others they have inspired, have addressed a wide range of real-life policy problems in the developing world using the same approach, with hugely successful results.
Examples include discovering how best to get farmers to use more effective fertilisers, how to increase the uptake of safe water filters, how to improve patient safety in hospitals, how to spread advice most effectively about tuberculosis using community-based counsellors, and how to improve safety in public service vehicles.
The technique of RCT has even been applied in developed world settings. For example, experiments have been carried out with job applications, sending them out with names which strongly imply the ethnic background of the applicant and seeing if the response differs across groups. (It does.)
The approach of RCT is not without critics in economics, even now. An important issue, for example, is that experiments are typically on a small scale, and there may be issues when they are scaled up.
But Duflo and colleagues, unlike some past economics laureates, have definitely helped to make the world a better place.
As published in City AM Wednesday 16th October 2019
Image: Nobel Prize by Florian Pircher via Pixabay
Get ready to put your hands deep into your pockets for the boyos and girlos of the Welsh Valleys. Adam Price, the leader of Plaid Cymru, called last week for the UK to pay “reparations” to Wales for the crime of reducing the country to poverty. For centuries, Wales has (apparently) been stripped of its natural resources and “deprived of its inheritance”.
Price’s demands are almost beyond parody. But they could become a frightening reality if a coalition government led by Jeremy Corbyn and various nationalist and green parties wins the next election.
The then-Labour leader of the Welsh Assembly, Carwyn Jones, set the new tone of Welsh whingeing the day after the Brexit vote in 2016. “Wales,” he declared, “must not lose a penny of subsidy”. Wales, of course, had voted Leave.
There, in a sentence, was the economic policy of the Welsh government: hold out the begging bowl.
Wales is the poorest of the economic regions of the UK. Household income per head in 2017 – the latest date for which figures are available – was only £15,754, compared to the UK average of £19,514. The gap with the wealthiest regions is massive – the south east has an income per head 43 per cent higher, and London is no less than 77 per cent ahead.
It has not always been like this. In the early decades of the Industrial Revolution, the valley towns were probably the richest in the world.
Merthyr Tydfil, now a byword for poverty even by the standards of Wales, led the way. It was the first genuinely industrialised town in the history of humanity. In 1831, 96 per cent of its labour force worked in manufacturing and mining.
Many forces are at work in the story of Wales’ decline, but in modern times, it has often not exactly helped itself. The key to a successful economy is a skilled labour force, but in 2001, the Welsh government scrapped the publication of league tables for the performance of schools. This both deprived parents of information, and reduced the incentive for poor schools to improve.
The outcome was predictable. A Bristol University study estimated that it led to a fall of 1.92 GCSE grades per pupil. In 2015, the Welsh Assembly reversed the decision, but a lot of damage had been done to the human capital of Wales. For over a decade, students were less well educated than they could have been.
This lack of a skilled talent base inevitably holds back enterprise. This, along with other counter-productive decisions, may be why Wales is increasingly dependent on public sector jobs. Overall, Wales raises £14bn a year less in taxes than it spends on public services.
Might Wales be able to turn its fortunes around if it were forced to consider its economic decisions more carefully? After all, the policy of subsidising underperforming regions has been tried for decades. It has made no difference.
So instead of paying reparations, perhaps we should consider withdrawing subsides, as New Zealand did with great effect. By removing the handouts which are distorting Welsh decision-making and causing a vicious cycle of subsidy demands, we can give Wales the chance to restore the enterprise which used to flourish in the nation.
As published in City AM Wednesday 9th October 2019
Image: Welsh Assembly by Anne Siegel via Wikimedia Commons licensed under CC by 2.0
Area 51 is a mysterious place.
Located deep in the Nevada desert, it is home to highly classified US military operations. Rumours abound that it harbours secrets about extraterrestrial life.
In June, a podcaster released an interview with someone who claims to have studied flying saucers in Area 51. The video spread like wildfire on the internet.
A proposal for an event took shape, labelled “Storm Area 51, They Can’t Stop All of US”. The idea was for large numbers to gather on 20 September in a couple of tiny Nevadan towns next to Area 51. The security defences would be overwhelmed. Citizens could then see for themselves the aliens being kept secret by the military-industrial complex.
Around two million individuals pledged on Facebook to attend. Estimates vary, but it seems that in reality only some 2,000 turned up in the nearby towns. Of these, a mere 200 or so actually arrived at the security fences which guard the area. No one tried to cut or climb over the barriers.
The event has subsequently attracted a great deal of ridicule in both the mainstream and social media. But it usefully illustrates two important principles in economic theory.
The first is the so-called free rider problem. It occurs when some individuals fail to contribute their fair share to the cost of a shared product or services.
An everyday example is that of a shared kitchen space in an office block. Provided enough people are willing to keep it clean, there is an incentive for others to free-ride and enjoy the clean kitchen without doing anything themselves.
The problem is that where free riders exist, the product or service in question tends to be under-produced. In the kitchen example, the supply of people willing to clean may drop off.
Exactly the same thing took place outside Area 51. Everyone wanted the razor wire fences to be cut, so they could consume the “product” of entering the site to see if it contained aliens. But not enough – in fact no one at all – was willing to cut the wire and incur the potential cost of being shot.
The event also illustrates the importance of revealed rather than stated preference.
Economists traditionally attach little weight to surveys in which people are asked hypothetical questions about what they might do or pay in different situations. These constitute stated preferences.
Instead, economists prefer to infer preferences from the actions people actually take. If you always buy Pepsi rather than Coke, you have revealed your preference between the two.
Pressing a button to say you “like” something merely states your preferences. The cost of doing this is virtually zero. Revealing preferences may involve substantial costs, such as travelling to the Nevada desert.
This fundamental point is being lost in many of the reactions of decision-makers to events on social media. Far too much importance is being attached to actions which are almost costless.
The UFO buffs of Area 51 have done a public service by providing a clear example of this principle, and of evidence that “likes” do not necessarily equal action.
As published in City AM Wednesday 2nd October 2019
Given the climate of intense uncertainty, the FTSE index remains remarkably resilient.
It currently sits almost bang in the middle of the 7,000-7,600 range, where it has been since the beginning of January 2017.
Brexit does not seem to trouble share prices. Nor do the threats by John McDonnell, Labour’s shadow chancellor, to carry out extensive raids on shares and put workers on the boards of companies.
These risks and uncertainties are “priced in” by the market. The concept of market efficiency, revered by economists, means that all available information is taken into account in the process of setting share prices. The implication is that pension funds and traders alike appear to attach only a small probability to a disruptive Brexit or to Labour forming a government.
Of course, it is precisely when an unexpected disruptive event takes place that the market ceases to be efficient. Market participants need time to absorb and process the implications of the new environment, and do so at different speeds. There is widespread disagreement about what the “rational” price of an asset is, and as a result volatility abounds.
So despite the sanguine way in which the market is currently behaving, there must be many investors in shares of various kinds who are casting anxious eyes back over their shoulders.
They can take comfort from an article published in the latest Quarterly Journal of Economics by Oscar Jorda, of the University of California, and colleagues. Its findings represent an important addition to scientific knowledge.
The authors publish estimates of the annual total returns on equities, housing, long-term government bonds and short-term fixed interest government securities (three-month Treasury bills in the UK). The impressive nature of the work is not simply that it covers 16 advanced economies. Data is provided for every year between 1870 and 2015.
Government debt in countries like the US and the UK is considered a “safe” asset. But one of the most remarkable findings of the research is that the real return (in other words gains after allowing for inflation) on such assets has been very volatile, often even more so than the supposedly “risky” assets such as equities.
This is quite contrary to the conventional view of how the world is supposed to work. If one asset gives a higher return than another, the expectation is that its price is more volatile. There is a trade-off between risk and return. But this seems not to be the case in reality.
Intriguingly, both equities and residential real estate have yielded total real gains of no less than seven per cent a year. Housing outperformed shares from 1870 until the Second World War, and the position has been reversed since then.
Governments come and go, as indeed have two major world wars. But over the course of well over a century, holding equities and not worrying about short-term fluctuations has yielded rich rewards.
Obviously, the past is not necessarily a guide to the future – but the past here spans evidence from nearly 150 years. Something to think about if you’re looking to invest at a time of such global political uncertainty.
As published in City AM Wednesday 25th September 2019
Image: Investment via Pixabay
The latest American Economic Review contains a timely paper. Keith Head and Thierry Mayer, at the University of British Columbia and the Banque de France respectively, estimate the consequences of changes in tariff and non-tariff barriers to the car industry.
They look at both US-led protectionism and Brexit, and calculate how these might change the location of production.
The car industry is of course the tradeable industry par excellence. For example, 50 per cent of cars sold in OECD markets are assembled in locations that are neither the headquarter nor the consuming country.
The United States had threatened to impose so-called Section 232 tariffs of 25 per cent on cars imported from Canada and Mexico on national security grounds. And President Trump did bring in such tariffs in aluminium and steel, although in the summer America reached separate bi-lateral agreements with Canada and Mexico.
Head and Mayer estimate that Section 232 tariffs would have devastated the Canadian and Mexican car industries. Even if the two countries retaliated, car production would have fallen 40 per cent in Mexico and 67 per cent in Canada.
A key reason for these massive numbers is that almost all the brands made in Canada (11 of 12) and Mexico (10 of 14) are also made in the US. Under tariffs, there would be a strong incentive to shift production to America.
The results for the Brexit scenario are quite different.
The simulation is of a hard Brexit. UK exports face the European Union’s 10 per cent Most Favoured Nation tariffs, and Britain reciprocates at the same rates. The authors assume that we cannot roll-over existing EU agreements with third-party nations, and that the tariff structure with them reverts to the same basis.
The EU runs a large trade surplus with the UK in cars, so higher tariffs mean that we have less to lose. The British car industry actually gains through the protective effect of tariffs.
Overall, Head and Mayer estimate a fall in production of only four per cent. This arises purely from their calculations of trade with countries such as Turkey and South Korea.
The paper is impressive in its detail and in the rigour of its analysis. These are the great strengths of much modern economics.
Of course, it also has its weaknesses. The analysis is, to use a jargon phrase, a purely static one: it takes the technology and the structure of production as given, and traces how tariffs, by changing costs and so the incentives of firms to produce in different locations, work through the industry.
It does not take into account any dynamic changes: how productivity or innovation (which alter the structure of production) might respond to changed circumstances.
Assessing these factors is a much harder task. Most would agree, for example, that a hard Brexit under Jeremy Corbyn would lead to ossification, although this is a matter of judgement and not analysis.
Still, despite these limitations, the study shows that the impact on production of a hard Brexit even in an industry which thrives on trade would be negligible. It makes interesting reading at a time when hysteria over a no-deal Brexit is once again reaching a fever pitch.
As published in City AM Wednesday 18th September 2019
Image: Final Assembly by Brian Snelson via Wikimedia is licensed under CC BY 2.0
The Autumn Spending Review announced by the chancellor Sajid Javid barely raised a ripple last week.
Yet the increase planned in 2020/21 for what the Treasury calls “day-to-day departmental spending” is the highest for 15 years, no less than 4.1 per cent in real terms.
This spending pays the running costs of public services, the main component of course being public sector wages. An increase of this size ought to mean better services, although the Gordon Brown years demonstrated quite clearly that more spending need not mean an improved service.
This number only represents 37 per cent of total public spending. Considerably more is spent on welfare benefits, pensions, and interest on the national debt. The squeeze is still on here, so the overall rise in total current public spending is more modest, at just 2.0 per cent after allowing for inflation.
Nevertheless, Javid’s plan does represent a step up in the move away from austerity envisaged by the former chancellor Philip Hammond in last year’s autumn Spending Review.
Still, this pales in comparison to what is envisaged for the public finances under the current Republican administration in the US. The Congressional Budget Office (CBO) there notes that the federal budget deficit for 2019 will be $960bn. Budget deficits are projected to average $1.2 trillion a year between 2020 and 2029.
The CBO calculates that this will push up federal government debt to 95 per cent of GDP, the highest level since the late 1940s.
On both sides of the Atlantic, the move away from austerity represents a major shift in the narrative around public sector debt. It is now, it seems, okay to feel relaxed about government borrowing.
The mood in mainstream academic macroeconomics has also shifted. Ken Rogoff, a former chief economist at the IMF, said in 2010 that a debt-to-GDP ratio above 90 per cent risked a substantial reduction in the long-term growth rate (a view shared by many in developed countries), triggering a wave of austerity.
Yet in February this year, he changed his tune, saying that the steady decline in global real interest rates meant that the debt-to-GDP ratio was no longer a concern.
Olivier Blanchard, another former IMF chief economist, made a similar point earlier this year, when he argued that, as the real rate of interest is lower than the real growth rate, future interest payments on debt could be met out of the proceeds of growth.
While this is not necessarily unusual (such a state of affairs has been the case often enough in the last 150 years), the argument that governments should use it as an excuse to build up debt very definitely is.
The shift in attitude has implications in politics, too. For years, right-wing parties have painted the left as being as being spendthrift and irresponsible.
With an election seemingly inevitable in the UK, it will be interesting to see whether the Conservatives – having turned on the taps – can make that narrative stick to Jeremy Corbyn.
As published in City AM Wednesday 11th September 2019
Image: Taps via PxHere is licensed under CC0 1.0
The expulsion of Bury FC from the English Football League last week continues to generate a huge amount of sound and fury.
Regardless of the apparently dodgy nature of some of Bury’s transactions, the simple fact is that the club overspent massively in order to gain promotion from League Two last season.
The surge in the costs involved of running a football club has been dramatic. Over the summer, for example, Premier League clubs were involved in transfer deals worth a collective £1.4bn. Marcus Rashford signed a new contract with Manchester United in July worth £250,000 a week, and quite a few players get even more.
Professional sporting clubs are an unusual sort of beast from the perspective of economic theory.
Economists agree that companies act to maximise profit. The concept is not completely clear-cut – a pricing policy, for example, which gouges customers and increases profits this year may eventually prove disastrous.
But generally sustainable profit is the aim. But sporting clubs do not even attempt to maximise profits. Their principal motivation is to maximise costs. Spending more money means getting better players. And better players mean more success on the field.
The correlation between the total amount a team spends on its players and its league position is not perfect, but it is high. It is the principal reason for success. So there is an inherent tendency for clubs to live beyond their means, unlike almost all other businesses. It is performance on the field which matters.
The behaviour of clubs, however, nicely illustrates another concept in economics. This is the potential conflict between individual and collective rationality. It is the collective interests of top soccer clubs to scale down the payments to players. The problem for clubs is that if they offered stars laughably small amounts, say a mere £100,000 a week, other top clubs both here and in Europe would entice them away.
It is not in the individual interests of the club to allow this to happen.
One possible solution is for the regulatory body of a game to impose a binding salary cap, limiting the total amount which can be spent on a team.
This works well in American football, for example. As an approximation, all the teams spend the full amount. So unlike soccer, where a handful of clubs dominate, success rotates around.
There was, in fact, a maximum wage in force in soccer until 1961. It was only twice average earnings, around £1,200 a week in today’s money, and was ended by the threat of a players’ strike.
Nowadays, of course, players able to perform in the Premier League are part of a global market. American footballers are not. The game is hardly played anywhere else.
Players with Premier League skills thus are exported to and imported from abroad – what economics describes as a tradeable market. In the lower divisions, however, the players are non-tradeable in this sense.
A salary cap, no matter how tightly drawn up, is always open to creative abuse. But economics suggests that it is the way forward for teams in divisions below the Premier League.
As published in City AM Wednesday 4th September 2019
Image: In Memory of Bury FC by David Dixon via Geograph is licensed under CC BY-SA 2.0
A report published by Deloitte a couple of weeks ago will have enhanced the feeling of holiday wellbeing for many people.
The median annual pay for bosses of FTSE 100 companies fell in 2018 to £3.4m, compared to £4m in 2017.
This is the lowest level since 2014, when the UK brought in rules which require firms to report a single figure for chief executive pay.
Criticism of the remuneration of top corporate executives has been growing strongly for some time. In June, for example, the shareholders of Netflix voted down – albeit by a very narrow margin – the firm’s executive officer compensation plan.
Netflix grew from nothing in 1997 to a current value of around $150bn, and over the last four years its share price has almost trebled. But shareholders still did not like the chief executive’s proposed package.
Top executives may feel rather aggrieved at this mounting unease over their “emoluments” – a much more suitable word for these grandiose packages.
After all, does not basic economics provide a sound justification for their pay? In the textbooks, prices are set by the interaction of supply and demand. If something is in short supply, such as the skills of executives, the price will be bid up.
Remarkably, a more sophisticated version of this argument is advanced by some leading members of the economics profession.
Greg Mankiw, a top Harvard economist, is one of the biggest cheerleaders. Technological change, he argues, usually increases the demand for skilled labour. As such, unless society is able to educate and train people so that the supply of skilled labour increases at least as much as the demand, the earnings of skilled workers will rise relative to the rest of the labour force.
Technology is further invoked by some to justify the pay of those at the top. Because of a truly dramatic increase in the level of connectivity in society, highly talented individuals have been able to leverage their talents across global markets and capture rewards that would have been unimaginable in earlier times.
This is certainly the case with stars of popular culture and sport. A hundred years ago, for example, the only people who could have any direct experience of Manchester United playing football live were those present in the stadium during the game. Now, the team can be watched by literally billions around the world, using a variety of delivery channels, and the players reap huge amounts as a result.
However, it is not at all apparent that the same argument applies to corporate executives.
The huge growth in business schools in recent decades, for example, has presumably led to a substantial increase in the supply of people capable of filling top executive roles.
The fact is that, in many situations, there is an inherent indeterminacy around a price – or a pay package – when it is being set. The Oxford economist Francis Edgeworth argued over a century ago that “in pure economics there is only one theorem, but that it is a very difficult one: the theory of bargain”.
Corporate executives have certainly exhibited great bargaining skills in recent decades. But it seems that, at last, their bluff is being called.
As published in City AM Wednesday 28th August 2019
Image: Handshake via pxhere licensed under CC0 1.0
August is traditionally the silly season. Brexit makes this year slightly different, of course, but it is good to see a fine British tradition still being preserved. Silly stories abound.
Sajid Javid was linked (erroneously, he now claims) with the idea of fixing the housing market by making sellers pay the stamp duty rather than the buyers.
Sentiment around the housing market has been weakening for some time. This is certainly the case in London, where the large amounts of duty charged on expensive sales have acted as an additional deterrent.
But we might reasonably wonder how shifting the tax from the buyer to the seller will make any difference at all.
An activity, the sale of a house, is being taxed. At one extreme, the buyer could offer the asking price less the full amount of the tax. At the other, the seller could add the tax to the price. Or the two could strike a bargain around what proportion each will pay. It really does not matter who is legally responsible for the tax – its existence will still have an impact on people’s desire and ability to buy and sell.
An even dafter policy idea emerged from Bright Blue, ostensibly a “pressure group for liberal conservatism”. The think tank seems to have forgotten the most basic principles of how economic incentives operate.
The policy wonks proposed higher fines for motorists who leave their engines idling. They went on to suggest that a proportion of the fines should be paid to the people who reported offenders to the police. So for the cost of a phone call or the time spent composing an email, you could trouser around £50.
That beats working as far as most people are concerned. The police would be swamped, not just with genuine incidents, but with scores being settled.
And Prince Harry seems to be having a silly season all of his own. He suggested that people can be “unconsciously” racist. He himself demonstrates how “unconsciously” one can win the Monty Python Upper Class Twit of the Year award.
Not content with lecturing a Google gathering in Sicily, attended by hundreds of private planes, on the evils of climate change, he and Meghan Markle flew for a six-day break to Ibiza, again on a private jet. Only 48 hours after their return, off they went again on an “Uber for billionaires” to Nice.
It is in these trying times that the house Bible of the metropolitan liberal, the Guardian newspaper, reliably provides light relief. The travel pages eulogise “eco-lodges” in places halfway across the world like Cambodia and Peru.
A piece last week created mental agony for the writer. A social enterprise, Beyond Food, is helping homeless people turn their lives around by teaching them a skill– a Good Thing not just in itself, but because it is not run by wicked capitalists.
But the skill is how to barbecue meat – boo, hiss. At least, we are assured, the meat is “sustainable”.
Markets, incentives, and social norms are the standard meat and drink of this column – and normal service on them will be resumed next week, when silly season is at last drawing to an end.
As published in City AM Wednesday 21st August 2019